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 COST OF CAPITAL

Cost of Capital

• As we discussed that companies make investment, financing and dividend

decisions. FINANCINGT
•
•
Long-term investment decision techniques have been discussed already.
Tostofis
In cost of capital, we are going to talk about financing decisions. Cost of financing
capital is one of the techniques used before finalizing on how to finance a cost of
new project. capital
• Cost of capital is the total cost of financing a project. It includes:
o Interest cost INVESTOR
o Repayment cost Tow
• Cost of capital’s interest cost also provides advantage or savings in the
investments

Is
form of “deduction of interest from revenues before paying tax”. This
advantage is taken into consideration while finding out the total cost of
financing. raisingfinance
• A company’s COC is the average cost of various securities (Capital 7TH
components) employed by it. It is the average rate of return required by 1DlNlDINDI
the investors who provide capital to the company.
1 in short
interest paid to
Rationale for Using COC: lenders
• The rationale is that if a firm’s rate of return on its investment exceeds its
c
cost of capital, equity shareholders benefit. For example, the cost of equity of
shareholders is 14% and cost of debt is 6%. The cost of capital, which is
weighted average cost of capital, works out to be 10% (0.5 * 14% + 0.5 * 6%). assuming
If the firm invests Rs 100,000 on a project which earns a return of 12%, the 50
equity
return on equity funds would be: 50 debt
Total returns from the project – interest on debt / equity funds

100 (0.12) – 50 (0.06) / 50 = 18%

1 Row 30 Gnterestpaid 9000
Since 18% is more than cost of equity (14%), the project is acceptable.
t
9000 on
Formula of cost of capital:
B0 (net proceeds from financing) = sniffed
SUCCESSRBI@ANUJJINDAL.IN 1
 COST OF CAPITAL
IKE i not l w
I (1 – t) / (1 + Kd)1-n + cash outflow / (1 + Kd)1-n
is ofa sum
frothis
Kd cost of deby
Kp host of preferred
Here, I = interest rate charged on the borrowing made
t = tax rate charged on revenues stock
Imp A
Kd= after tax cost of capital of debt teleost of equity
to
Remember
n = total duration of debt raising
B0 = net proceeds received from the issue

Example: cost of capital in case of debt

A ltd issues 12.5% debentures of face value of Rs 100 each, redeemable a t

the end of 7 years. The debentures are issued at a discount of 5% and
floatation cost is estimated to be 1%. Find out the cost of capital of these
debentures given that tax rate is 40%

Solution:
Net proceeds from the issue (B0) = 100 – discount – floatation cost = 100

D
– 5% (5) – 1% (1) = 94
debt are
I = 12.5 (1- tax) = 7.5 both interest and cost of tax
Put in the above equation: taken on an after basis

94 = 7.5 / (1 + Kd)1 to 7 + 100 / (1 + Kd)7

R 7th4
II ft Kd Mrs Had
Since repayment is made after 7 years (redemption), the time period is
written as only 7
Interest is to be paid every year, taking time period as 1 to 7 years
The left hand side is to be made equal to right hand side. In order to find
Kd, we use trial and error:

At Kd = 8%, the value of right hand side is:

PV of interest paid after one year = 7.5 / (1 + Kd) 1 = 6.944

PV of interest paid after 2 years = 7.5 / (1 + Kd) 2 = 6.430

SUCCESSRBI@ANUJJINDAL.IN 2
 COST OF CAPITAL

PV of interest paid after 3 years = 7.5 / (1 + Kd)3 = 5.954

PV of interest paid after 4 years = 7.5 / (1 + Kd) 4 = 5.513
PV of interest paid after 5 years = 7.5 / (1 + Kd) 5 = 5.104
PV of interest paid after 6 years = 7.5 / (1 + Kd) 6 = 4.726
PV of interest paid after 7 years = 7.5 / (1 + Kd) 7 = 4.376

It comes out to be 39.05

The second part is redemption after 7 years, which is 100
PV of redemption is 100/ (1 + kd)7
Which is 100 (0.583) = 58.30
Adding interest payments and redemption, we get right hand side as
97.35

This can also be found out by using the following formula-

PVAF = (1 – 1/(1 + i)n ) / I = (1 -1/ (1+0.08)7) / 0.08 = 5.206 a Thinsmaify Fetor
Now using PVAF, we can find out
I (1 – t) / (1 + Kd)1-n + cash outflow / (1 + Kd)1-n for a 7years

as:
7.5 (5.206) + 100/ (1.08)7 = 97.35

since this value is greater than the required value (94), in order to reduce
this value, we increase Kd assumed to 9%
at 9%, right hand side would be:
PVAF = (1 – 1/(1 + i)n ) / I = (1 -1/ (1+0.09)7) / 0.09 = 5.033 as annudity factor
7.5 (5.033) + 100 (1.09)7 = 92.45

Now, exact cost of capital (Kd) can be found by using the following
formula:

Kd = I (1-t) + Redemption Value – net proceeds / N

Redemption Value + net proceeds / 2

SUCCESSRBI@ANUJJINDAL.IN 3
 COST OF CAPITAL

Here, Kd = 7.5 + (100 – 94) / 7 = 0.861 or 8.61%

(100 + 94) / 2

There is a shortcut formula to find out approx. cost of debt:

7 5 11100 94117 9725

705 0 0866
rD = I + (F – Po) / n
B 0.6 94 to 4 100 56.41 40 8 66
0.6 Po + 0.4F

REVISION GRID FORMULAS

where,
F is face value
I is interest a.IETnti
ii IF
n is period to maturity ao.pvAr
fl fIegn liN
Po is the current market price
Kd Id t V t IN
t.fi
If all the above figures are provided in a question, the above shortcut formula can
be used to arrive at approx. value.
Shortcut formula
kBo
ID I 1 F Po n
t4
Difference between company cost of capital and Project cost of capital:

Company cost of capital is the rate of return expected by the existing capital
providers and reflects business risk of existing assets and capital structure.

On the other hand, Project cost of capital is the rate of return expected by capital
providers for a new project or investment the company proposes to undertake.

SUCCESSRBI@ANUJJINDAL.IN 4
 COST OF CAPITAL

Cost of capital for Equity:

• The measurement of cost of capital of equity share capital is the most

typical and difficult exercise. It is difficult because the starting point of
interest payments in debt is not available in case of equity. The issuer
may decide to pay dividends or retain the profits in the firm for
reinvestment and expansion.
• P0 = D1 / (1 + ke)1 + D2 / (1 + ke)2 + D3 / (1 + ke)3 … Dn / (1 + ke)n +
Pn/ (1 +ke)n
• P0 = current market price of equity share
• Pn = share market price after n years
• Di = dividends receivable by the investor over different years
• Ke= required rate of return of the shareholder or cost of equity share
capital
exampies
Market price per share 20
For zero growth dividends:
Earning per share 1
Formula- PIERatio 20 1 20
ke cost
D D
Ke = D1/ P0 ooo05
To ofequity
PIE
As per this formula, Ke is inverse of P/E (price-equity) ratio. EFI what the market
is willing to pay
for
Sometimes, dividend grows every year. If dividend in this year is 10 rupees, it
would be 11 rupees given that growth % is 10% every year. Similarly, after two
companys
earnings
years dividend would be 12.1 rupees.
For constantly growing dividends:
Formula-
P0 = Do (1 +g) / (1 + ke)1 + Do (1 +g)2 / (1 + ke)2 + … + Do (1 +g)n / (1 + ke)n
This formula can also be written as- P0 = D1/ Ke – g
Where g = growth rate per annum
f D

SUCCESSRBI@ANUJJINDAL.IN 5
 COST OF CAPITAL

Example:
A ltd has declared a dividend @ 15% on equity share of Rs 100 each. The
expected future growth rate in dividends is 12%. Find out the cost of capital of
equity shares given that the present market value of the shares is Rs 168

15 12 Ro 2 168
Solution:
Do
do
g a

Using the formula, P0 = D0 (1 +g) / Ke –g 15 on face value

i e too
168 = 15 (1 + .12) / ke - .12 of equity
ke = 16.8/168 + 0.12 = 22%

Cost of capital of Preference shares:

• Cost of capital of preference shares is calculated similar to COC of debt
due to treatment of preference dividend as interest in calculation.
• In both equity and preference shares, “Corporate dividend tax” has a
direct impact on equity and preference dividends.
• Formula- P0 = PD1 / (1 + ke)1 + PD2 / (1 + ke)2 + PD3 / (1 + ke)3 … PDn / (1 +
ke)n + Pn/ (1 +ke)n
• Formula for irredeemable shares- Ke = PD/ P0
• There is no tax saving from a preference share’s dividend payment. Thus,
D
unlike debt, preference share COC does not consider tax advantage.
• The calculation for “Corporate Dividend Tax” has been shown below.

Example-
A ltd. issues 15% preference shares of face value of Rs 100 each at a floatation
cost of 4%. Find out the cost of capital of preference shares if the preference
shares are redeemable after 10 years at a premium of 10%.

Solution-

SUCCESSRBI@ANUJJINDAL.IN 6
 COST OF CAPITAL

96 = 15 (1 + 0.20) / (1 + Kp)1-10 + 110/ (1 + Kp)10

B long method
P.D
lhhfqap R.tltKp
tqpo
Using the formula- PVAF = (1 – 1/(1 + i)n ) / I, at 16% we get the right hand side
as
PVAF = (1 – 1/ (1 + 0.16)10 )/ 0.16 = 4.833

Right hand side = 15 * 4.833 + 110 * 0.227 = 97.46

Since it is higher than 96, we need to increase the Kp to arrive below 96
At 17%, right hand side comes to be:

PVAF = (1 – 1/ (1 + 0.17)10 )/ 0.17 = 4.659

15 * 4.659 + 110 * 0.208 = 92.76

now, interpolating Kp using the below formula, we get:

Kp = L + (A – P0) * (Kp1 – Kp2) / ( A – B) Imps

Where, L = lower interest rate among the two used to calculate Kp
A = value of Preference share at lower Kp
B= value of Preference share at higher Kp
P0 = value of left hand side
Kp1 = Value of lower Kp
Kp2 = higher Kp

Kp = 16% + ( 97.46 – 96) (17-16) / (97.46 – 92.76) = 16.31%

Situation 2: when corporate dividend tax of 20% is included in the question, the
value of Kp will change as follows:

Preference dividend will change from 15 to 15 (1 + 0.20) = 18

In place of 15, we will use 18 at all places and find out Kp accordingly using the
same formulas as used above.

SUCCESSRBI@ANUJJINDAL.IN 7
 Weighted Average cost of capital (WACC):

• Weighted average Cost of capital means calculating the average of all costs of
capital (debt, equity and preference), which might be a part of capital
structure of a firm.
• It is calculated by multiplying specific cost of each source of financing by its
proportion in the capital structure and adding weighted values.
• WACC = w (equity) * r (equity) + w (preference) * r (preference) + w (debt) *
r (1 – tax) (debt)

For example,
The cost of equity is 16%, cost of preference shares is 14% and cost of debt is
12%
Market value of proportions is 60%, 5% and 35%. tax rate is 30%.

WACC = 0.60 * 16 + 0.05 * 14 + 0.35 * 12 (1 – 0.30) = 13.24%

WACC if floatation cost is involved:

Formula-
Revised WACC = WACC / 1 – floatation cost

For example,
WACC is given as 12% and floatation cost on equity is 6%,
Revised WACC = 12 / 1 – 0.06 = 12.77%

Weighted Marginal Cost of Capital (WMCC):

Weighted average cost of capital tends to rise as a firm seeks more and more capital
because as suppliers provide more capital, the rate of return required by them tends
to increase.
WMCC shows the relationship between WACC and additional financing.

Any set of portfolio with WMCC below the expected returns is accepted. As soon as
WMCC rises above Expected returns, the project is to be rejected.

Example discussed in video on WMCC

REVISION GRID FORMULAS
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to Kee DilPo
Ta Po Dil Ke
a
g
Ba Kp L t CA Po Xcp kpa KA B
TE whee Wi X re t Wrx rd t wz Vp
How to determine optimal capital Budget

investment marginalcostof
opportunity
schedule
capital
IRR
Project
wswof Region 2
capital
lol l t
Repton
1
l Newcapital
invested
optimal raised
capital
Budget

all projects whose

The firm should take
than cost of funds
IRR is greater 2
as in the region
IRR cost of funds
If to be rejected
the project ought